Economic and Regulatory Capital Allocation for Revolving Retail Exposures

The latest revision of the Internal Ratings Based approach of the Basel Committee on Banking Supervision’s New Capital Accord Proposal for retail portfolios contains a significant innovation relative to previous versions: the recognition that, for revolving credits, future margin income will be available to cover losses before a bank’s capital is threatened. We assemble a mini-portfolio of revolving exposures and we compare the capital charges generated by the latest Basel’s formula with the capital charges generated by two possible earnings-at-risk internal capital allocation models. We find that in general, Basel’s capital ratios are closer to those generated by our models for the groups with lower credit risk. We attribute the discrepancies to the different ways Basel and our models account for future margin income, to Basel assumptions about asset correlations, and to one our models taking macroeconomic conditions explicitly into account.

Introduction
Many large retail financial institutions have developed models to assess credit risk and to allocate their economic capital to different segments of their portfolios. A strong incentive to develop these models was provided in part by the release by the Basel Committee on Banking Supervision (BCBS henceforth) in 1999 of a consultative paper on a New Basel Capital Accord (NBCA, see BCBS, 1999) that will eventually replace the one currently in force, and of its subsequent revisions and proposed implementation details (BCBS, 2001 and BCBS, 2003). It is interesting to compare the capital allocations resulting from models that could conceivably be used internally by banks to those resulting from the application of the NBCA proposal.

Author: Roberto Perli and William I. Nayda

Source: Lancaster University Management School

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